The African Tax Administration Forum has identified transfer pricing as a critical issue for African tax administrations and has undertaken several initiatives to improve co-operation between the administrations to police transfer pricing. In South Africa, the South African Revenue Service (SARS) has also significantly increased its focus on transfer pricing and regularly undertakes transfer pricing audits with a very capable transfer pricing team. SARS applies the Organisation for Economic Co-operation and Development (OECD) Guidelines on Transfer Pricing to determine the appropriate transfer pricing policy for a multinational enterprise operating in South Africa.

However, the United Nations has published a Transfer Pricing Practice Manual for Developing Nations, which may be more appropriate in particular circumstances in Africa. Both publications accept the arm's length principle as a basic guideline to determine pricing between related entities in a multinational enterprise. Nevertheless, a multinational should not assume that the prices established for intra-group transactions under a typical worldwide transfer pricing policy based on the OECD Guidelines would definitely be accepted by the African authority concerned.

The fact that transfer pricing is not an exact science, and that there is no single answer to any transfer pricing dispute, makes it difficult to ensure a consistent approach by different tax authorities. This could result in double taxation and expanded disputes with local tax authorities. It is thus critical for multinationals to have good connections with local firms in the African countries concerned to assist them with negotiations on transfer pricing disputes.

In addition, it is important to note that transfer pricing disputes are now frequently taken either to the local courts or to an arbitration forum, which implies that the authorities are becoming more litigious! This makes it important to ensure that the transfer pricing policy of the multinational is appropriately documented and implemented by a local law firm, and supported by objective information and economic analyses. It is no longer sufficient to do a very basic search of comparables on an international database and to then elect a price in the very wide range obtained, without appropriate adjustments to reflect the economic realities of the actual situation. It is doubtful that such general pricing analyses will stand up in court if challenged by the capable teams now employed by the tax authorities in several African jurisdictions.

Multinationals operating in Africa often regard operations in African countries as less valuable than those of the parent or other foreign group companies. The transfer pricing policies then reflect this by merely allocating a small margin on costs to entities Africa, arguing that the cost plus method is justifiable where the local entity merely provides a minor service, and that the local company is not required to take many of the risks relating to the sales in that jurisdiction.

For example, instead of using a fully fledged manufacturing and distribution subsidiary in the African country concerned, the multinational appoints the subsidiary as contract or tolling manufacturer, to provide the service of manufacturing the goods for the foreign principal in the group. The contract manufacturer is remunerated for services rendered to produce the goods and does not participate in much of the profit from the subsequent sales in that jurisdiction by the principal.

The principal would then often still use the subsidiary to sell the goods in the market, but would either use the subsidiary as agent to solicit orders, without contractual capacity, or sell the subsidiary on a stripped-buy-sell basis - that is, where all the risks are taken by the principal such as credit risk, currency risk, product risk and theft. The distributor is then in a similar position to an agent, which means that it cannot justify a margin much higher than the commission of an agent. The end result is that although many of the functions contributing to the sale of goods in that jurisdiction are performed in the local jurisdiction, only a small portion of the profit is allocated to the local subsidiary in terms of transfer pricing guidelines.

These practices can be in line with the OECD Transfer Pricing Guidelines, but they may result in the creation of a permanent establishment (PE) for the principal in the local country. For example, on the basis that the principal is holding inventory in the local country which is not held merely for purposes of delivery but also to facilitate sales by the subsidiary for the benefit of the principal, that is, the activities of the principal in the local jurisdiction may exceed the limited activities allowed under the typical PE provisions of an applicable double taxation agreement (DTA) with that country. This would allow the African country to impose tax on a portion of the profits realised by the principal to the extent that such profits could be regarded as attributable to a PE. Transfer pricing principles are generally also applied to determine what portion of the profits may be so attributed to the PE.

Multinationals also frequently charge high royalties to the African subsidiaries for the use of intellectual property (IP) owned by the foreign parent. It is very difficult to determine the arm's length rate for such IP royalties, which makes it difficult for the local tax authorities to dispute the rate. However, many African jurisdictions simply restrict the royalty rate under exchange control restrictions to some arbitrary rate, making it impossible for the multinational to extract arm's length royalties. In such cases, the compensation required by the foreign parent is often extracted in another form, such as increased cost for the supply of components used by the subsidiary, or through fees for services rendered.

It is also problematic to find evidence of arm's length fees for intra-group services. Typically such fees are determined using the cost plus method. However, the margins in respect of a particular service are difficult to establish and information in this regard on international databases fluctuates significantly. Multinationals could thus use the upper range of such a range to determine a fee for intra-group services and thus extract high margins.

African tax authorities are becoming much more competent in identifying these strategies and they frequently attack margins determined under international transfer pricing analyses. These disputes often end in complex settlement negotiations where the authorities are driving a tough bargain! It is thus important to ensure meticulous planning of an appropriate transfer pricing strategy which can stand up to the challenge in this litigious environment. Furthermore, it is critical to secure the support of experienced and competent tax litigators who can support you in these disputes.

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